This article was authored by Davis Byrd, Financial Planning Associate.
Imagine two people washing their hands. Not a particularly difficult visual in today’s environment, is it? The first person applies soap, rinses their hands, and dries them off. Meanwhile, the second person rinses their hands, applies soap, then dries them off. Yuck. Both people have performed the same tasks in the same amount of time, but only one person has properly washed their hands. Why? Order matters. Similarly, the order in which your investment returns occur can have a dramatic impact on how long a portfolio can sustain a stream of income for a retiree.
While it is true that an investor will receive a particular average return in the long run, it is a mistake to assume that you will earn that same long-term average each year. In other words, you may average 6% over the long run, but you won’t make 6% each year. Returns are expected to fluctuate, and periods of negative returns are not abnormal. In the example below, Bill & Jane both average 6% and both suffered a year when they lost 25%.
But that’s only part of the story. For those who are taking retirement distributions, the sequence in which you receive your annual returns impacts the longevity of your portfolio. To illustrate, consider Bill & Jane, two hypothetical retirees. Both will retire at the same age with portfolios of $1,000,000, withdraw $40,000 at the start of each year, and earn a long-term average of 6% on their investments in their first four years of retirement. The caveat – the order in which their returns occur will be inverse. Note that the annual withdrawals are inflation-adjusted at 2.25%.
|Year||Withdrawal||Bill's Portfolio||Bill's Return||Jane’s Portfolio||Jane's Return|
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